ESG AND SUSTAINABILITY FROM THE INVESTOR'S PERSPECTIVE
HOW INVESTORS APPROACH AND IMPLEMENT ESG AND SUSTAINABILITY GOALS
In this handbook, the term "institutional investor" covers a number of different entities that invest funds, typically in order to support a particular purpose. Institutional investors include pension funds (U.S. public pension funds, ERISA plans, and foreign pension funds) and sovereign wealth funds, as well as nonprofit organizations such as universities, private foundations, and public charities. The term also includes large family offices. Institutional investors can be divided into two major groups: those that have fiduciary duties because they are, in effect, investing funds for the benefit of other persons, and those that do not have fiduciary duties.
Institutional investors that are fiduciaries have various approaches to dealing with ESG and sustainability issues. However, they are consistent in viewing ESG and sustainability analysis through the lens of their fiduciary duties to their beneficiaries or the purposes of their institutions.
Some institutional investors view investing according to ESG or sustainability principles as a version of impact investing or socially responsible investing, which they find difficult to justify from a fiduciary standpoint. To the extent that the purpose of these investing methodologies is to achieve societal benefits, that purpose may be inconsistent with the institution's obligation to provide the benefits for which it was formed. In the extreme case, investment returns may be sacrificed for the societal objective. Even if an impact or socially responsible investment does not detract from returns, an investor that actively seeks such investments may be seen as improperly devoting resources in order to do so. Fundamentally, some investors may believe that ESG and sustainable investing involves a purpose other than the purpose for which the institution exists. Put another way, these investors would see themselves under a duty to invest purely for returns.
Other institutional investors see ESG and sustainability factors as key aspects of their investment decisions because these factors provide insight into the economic viability of their investments, especially over the long term. These institutions use ESG and sustainability factors to identify qualities that will enable the investments to increase in value, as well as qualities that may cause deterioration in value. For example, ESG and sustainability analysis has contributed in many cases to divestment from coal and hydrocarbon production, related infrastructure, and marketing companies, while spurring increased exposure to alternative energy investments. ESG and sustainability factors are also often taken into account in infrastructure investments, given the significant environmental and social impacts of these investments and their long-term nature, the success of which requires good governance. Further, ESG and sustainability considerations are seen as important in efforts to avoid acquiring and holding assets that may become stranded assets, especially those that lose significant value as the result of regulatory or environmental changes. In short, these investors may consider ESG and sustainability analysis not to be merely consistent with their fiduciary duties, but in fact to be required by their fiduciary duties.
Institutions that are not fiduciaries are generally understood to have more leeway to consider ESG and sustainability factors in reaching their investment decisions. Some may implement their ESG and sustainability policies in a similar manner of focusing on the potential effects of ESG and sustainability factors on financial returns. However, family offices may have more of a tendency to engage in impact or socially responsible investing, guided by the family's values. And of course, there are funds created especially to effect such investing—in this case, these funds have a fiduciary duty to invest with the required impacts in mind.
Institutions with ESG and sustainability policies, including fiduciaries and non-fiduciaries, may implement these policies both by eliminating certain sectors from their portfolio (e.g., private prisons, firearms, or alcohol) and by proactively investing in certain sectors (e.g., minority-owned businesses). Some fiduciaries will apply ESG and sustainability considerations in ways that they believe will indirectly advance the interests of their beneficiaries (e.g., construction unions favoring investment in real estate, and public pension funds avoiding investments in businesses that privatize public sector jobs).
Institutions that incorporate ESG and sustainability factors into their investment decision-making process do so in a number of different ways. In some cases, institutions have an ESG or sustainability team that reviews all or a specified portion of the institution's investments through an ESG and sustainability lens. This approach may have the benefit of a consistent treatment of these factors across investments. In other cases, ESG and sustainability analysis is an integral part of each investment officer's evaluation of opportunities. Many institutions choose to focus on certain enumerated ESG or sustainability factors in order to keep the evaluation and monitoring manageable. In particular, this approach may guide the institution's shareholder engagement and proxy voting policies for their public investments.
In sum, many institutional investors are still feeling their way as they develop their strategy for dealing with whether and how to incorporate ESG and sustainability issues into their investing decisions. There is a broad spectrum of approaches in this area—from hesitating to consider ESG and sustainability issues at all, to identifying specific factors to pursue or avoid, to embracing the concepts as fundamental to their investment program, to seeking out investments with positive ESG and sustainability impacts.
UNIQUE CONSIDERATIONS OF ERISA INVESTORS AND PLAN FUNDS
U.S. retirement plan sponsors and other fiduciaries of private sector retirement assets that would like to consider ESG and sustainability factors when making investment decisions must consider ERISA, the U.S. federal pension statute. ERISA imposes strict investment duties on fiduciaries responsible for investing private sector pension plan assets, including fiduciaries with responsibility for selecting and monitoring investment options for 401(k) and other individual account retirement plans. The following are among the fiduciary duties imposed by ERISA (collectively, ERISA principles):
- A requirement that ERISA fiduciaries act solely in the interest of the plan's participants and beneficiaries, and for the exclusive purpose of providing benefits to the participants and beneficiaries and defraying reasonable expenses of administering the plan;
- A duty of loyalty, which requires ERISA fiduciaries to act with a single-minded focus in the interest of plan participants and beneficiaries; and
- A duty of prudence, which has been interpreted to prevent an ERISA fiduciary from choosing an investment that is financially less beneficial than an available alternative.
These fiduciary standards are the same regardless of the investment category, and as a result, present challenges for plan sponsors and investment managers that seek to consider ESG and sustainability factors when investing ERISA assets or offering investment options for 401(k) plan participants.
Over the years, the DOL has been asked to consider the application of ERISA's fiduciary rules to ESG and sustainable investing. DOL guidance has not been entirely consistent, and seems to vary based on whether there is a Democratic or Republican administration at the time it is issued. However, a consistent theme runs through the DOL's guidance: when making investment decisions, ERISA fiduciaries must focus solely on the plan's financial risks and returns.
On 30 October 2020, the DOL released its final rule "Financial Factors in Selecting Plan Investments" (the Final Rule). Although the proposed rule aimed to regulate ESG and sustainability investing by employee benefit plans subject to ERISA, in the Final Rule, the DOL rejected the ESG nomenclature as too unclear, removed all ESG terminology, and focused instead on whether a factor is "pecuniary." Broadly speaking, ERISA fiduciaries are not permitted to sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals, and may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives. Instead, a fiduciary's evaluation of an investment or investment course of action must be based only on pecuniary factors.
One exception under the Final Rule where ERISA fiduciaries can use non-pecuniary factors remains in a tie-breaking scenario (i.e., situations in which the fiduciary is unable to distinguish investment alternatives on the basis of pecuniary factors alone). To consider non-pecuniary factors as tiebreakers, an ERISA fiduciary must document: (1) why pecuniary factors were not sufficient to select the investment, (2) how the selected investment compares to the alternative investments, and (3) how the chosen non-pecuniary factor or factors are consistent with the interests of participants and beneficiaries in their retirement income or financial benefits under the plan.
If plan sponsors or retirement plan investment committees appointed by plan sponsors work with a consultant, the plan sponsor will have co-fiduciary responsibility over the plan's investments or fiduciary responsibility to oversee the consultant. In each case, the plan sponsor should consider ERISA principles and the Final Rule before an ESG or sustainability investment option is included in a defined contribution plan investment menu (especially as a default investment option) or causing a defined benefit plan to hire an investment manager who integrates ESG and sustainability factors into the investment process. Plan sponsors should (1) evaluate whether their consultants have sufficient expertise regarding ESG matters, (2) consider whether changes should be made to request for proposals and requests for information used in connection with hiring consultants, and (3) consider whether they have the necessary tools and expertise to evaluate ESG and sustainability matters in addition to more traditional investment matters.
On 10 March 2021, the DOL announced its plan to review the Final Rule, and that it would not enforce the Final Rule pending its review. Additionally, on 20 May 2021, President Biden issued an executive order directing the DOL to "consider publishing, by September 2021, for notice and comment a proposed rule to suspend, revise, or rescind" the Final Rule. In accordance with that directive, the DOL submitted a new proposed rule to the Office of Management and Budget on 6 August 2021, entitled "Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights." Therefore, we expect additional guidance and rulemaking in this area. However, any new rulemaking will be limited by the fundamental ERISA principles, and ESG and sustainable investing by plans subject to ERISA will remain an area with broad compliance considerations.
UNIQUE CONSIDERATIONS OF TAX-EXEMPT ORGANIZATIONS
Unsurprisingly, tax-exempt organizations often have a mission that reflects ESG and sustainability principles. For example, Parley for the Oceans is focused on mitigating the environmental impact of ocean plastics, as well as the health impact of consuming seafood that has internalized plastic and social impact on groups that live on coastlines. Emmaus International promotes systemic changes to eliminate human trafficking and forced labor, equalize access to finance, and accomplish environmental justice.
However, exempt organization investors are generally subject to regulatory requirements about how they deploy funds. In some cases, these requirements act simply as a screen, much like an institutional investor may screen for ESG and sustainability criteria. For example, in the United States, a mission related investment may be made by any exempt organization that wishes to invest its assets in an enterprise designed to have a positive social impact, while also generating a profit or other return on investment. In these cases, an exempt organization investor is likely to seek out evidence that the enterprise will somehow further the organization's specific mission, but otherwise may not differ significantly from a mainstream commercial investor.
In contrast, a U.S. private foundation1 may wish to qualify an investment as a program-related investment (PRI), as the foundation could then treat the investment similarly to a grant and avoid penalty excise taxes that might otherwise apply to this type of investment. An investment must meet these criteria to qualify as a PRI: (1) the primary purpose of the investment must be to accomplish one or more of the foundation's exempt purposes; (2) the production of income or appreciation of property may not be a significant purpose (i.e., a for-profit investor would be unlikely to make an investment on the same terms); and (3) influencing legislation or taking part in political campaign activity may not be a purpose. A PRI can take the form of a loan, equity investment, guarantee, or a hybrid investment.
Because a private foundation seeking to make a PRI would invest on less favorable terms than a typical investor, a PRI can provide a source of funding that would be difficult to attract from mainstream investors and can fill gaps where mainstream investors are not willing or able to take the associated risk. A PRI is also likely to add complexity to the negotiation and implementation of the investment, as the foundation likely will require substantial due diligence of legal, financial, and programmatic matters and the PRI rules will dictate certain terms of and processes related to the investment. Furthermore, the foundation is likely to require a side letter or other special agreement to memorialize the charitable purpose of the investment, the ongoing reporting and other requirements needed to comply with the PRI rules, and exit terms in the event that the investment can no longer qualify as a PRI.
From an Australian perspective, income or capital of a tax-exempt person must be made and distributed in accordance with the entity's objects and purposes and can only be made to persons or entities that come within the scope of beneficiaries described in the entity's constituent documents (which may not include the entity's members). When establishing an income tax exempt entity, significant care should be taken in considering the purposes for which the entity is established and the classes of beneficiaries for whom the entity is established. Incorrect identification of these matters at the outset—or failure to properly account for a change in purpose or beneficiaries—can cause significant issues for the operation and administration of these entities.
In Australia, an entity that has charitable purposes (including charitable purposes related to ESG and sustainability criteria) may obtain tax-exempt status by registering with the Australian Charities and Not for Profits Commission (ACNC). Entities registered with the ACNC must have one or more recognized charitable purposes, which could include advancing the natural environment and advancing social or public welfare. Entities that are registered with the ACNC will generally be entitled to various tax concessions, such as income tax-exempt status as well as certain Goods and Services Tax and Fringe Benefits Tax concessions, but also will be subject to ongoing oversight by the ACNC.
In addition to the above, entities with the principal purpose of protecting or enhancing the natural environment or providing information or education about the natural environment are eligible for deductible gift recipient (DGR) status allowing donors to receive an income tax deduction for donations made. Limited categories of organizations providing benevolent relief to sections of the community in recognizable need are also eligible for DGR status.
As to structure, ESG and sustainability-oriented entities can take several forms including, most commonly:
- As a company limited by guarantee, which will be regulated by the Corporations Act and may register with ACNC.
- As a private ancillary fund (PAF), a form of trust that manages gifts and then distributes them to other charitable organizations. PAFs are commonly used as charitable vehicles by high net worth families and institutions and are regulated by both trust law and specific legislative guidelines. PAFs typically have broad charitable purposes and are often registered with the ACNC under any of several charity subtypes.
ESG AND SUSTAINABILITY INVESTMENT FROM THE INVESTMENT SPONSOR'S PERSPECTIVE
FORMING AND MARKETING ESG AND SUSTAINABILITY INVESTMENTS AND FUNDS TO THE PUBLIC
The increase in the popularity of public ESG and sustainability-oriented funds is linked to the integration of ESG and sustainability factors into the mainstream, as well as improvement in performance of these funds. The impact of the climate crisis, underlined by COVID-19, has prompted greater awareness of the vulnerabilities of our planet, revealing the importance of ESG and sustainability investing and spurring record-high flows into ESG and sustainability equity funds in 2020.
To be recognized as an ESG or sustainability fund and to avoid greenwashing, a fund must either have a sustainable investment objective, or be identified as having environmental or social features (i.e., where sustainable investment is not the fund's primary objective but the fund manager makes a binding commitment, usually within pre-contractual documentation, to consider ESG or sustainability characteristics as part of the investment decisionmaking process).
ESG funds in Europe are most commonly set up as alternative investment funds (AIFs) or Undertakings for the Collective Investment in Transferable Securities (UCITS). In the European Union, marketing requirements for an AIF or a UCITS will, in the absence of the ability to take advantage of the EU passporting regime, depend on local marketing requirements in the country where the fund is being marketed. Meanwhile, managers of non-EU AIFs are only able to access the market through the National Private Placement Regime.
Marketing strategies must avoid greenwashing by ensuring that the objective of any fund is appropriately conveyed. In the European Union, marketing materials must be consistent with the new disclosure requirements under the new EU ESG and sustainability disclosure regime as further described under the section headed "EU Regulation on Sustainability Disclosures."
ESG funds in the United States are commonly established as open-end investment companies registered under the Investment Company Act of 1940, as amended. The Securities and Exchange Commission (SEC) has not yet established rules regarding what constitutes an ESG strategy, but comments provided by the staff of the SEC to funds that employ ESG strategies in the SEC registration process focus upon enhanced disclosure regarding the adviser's description of ESG and how it is incorporated into the fund's investment objective and strategies. In March 2021, the SEC included climate change and ESG-related risks on its list of examination priorities and announced a new enforcement task force focused on climate change and ESG-related issues. In April 2021, the SEC's Division of Examination issued a risk alert regarding ESG investing. As such, ESG investing is expected to be a continued area of focus by the staff of the SEC in examinations, the review of registration statements, and in upcoming rule proposals.
Further, in October 2020, the DOL finalized a rule aimed to regulate ESG investing by employee benefit plans subject to the ERISA. This rule prohibits plan fiduciaries from sacrificing investment return or taking on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals. Accordingly, if a fund integrates ESG factors into the investment process for non-financial reasons or discloses that investment performance may be adversely impacted because of the portfolio manager's consideration of ESG factors, an ERISA fiduciary, such as a consultant or a plan's retirement plan investment committee, may not be able to recommend or offer the investment product to defined contribution plan participants or cause a defined benefit plan to invest in the investment product. This would likely have had a resulting impact upon product design and disclosure. In March 2021, the DOL announced it will not enforce the Final Rule or otherwise pursue enforcement actions against any plan fiduciary based on a failure to comply with the Final Rule.
In May 2021, President Biden issued an executive order that directs the DOL to review the rule and gave the agency until September 2021 to "consider publishing...for notice and comment a proposed rule to suspend, revise or rescind" the rule. In accordance with that directive, the DOL submitted a new proposed rule for OMB review on 6 August 2021.
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